ADU Tax Deductions: What Homeowners Need to Know

Accessory Dwelling Units (ADUs) are gaining popularity as homeowners seek to increase property value and generate income. Understanding the tax implications is essential for those considering or owning an ADU. Tax deductions can provide significant financial benefits but require careful adherence to IRS regulations. This article breaks down key aspects of ADU tax deductions to help homeowners optimize their tax strategies.

Rental vs. Personal Use Classification

Determining whether an ADU is classified as a rental property or for personal use is crucial in understanding its tax implications. The classification determines the types of deductions available. The IRS considers an ADU a rental property if rented for more than 14 days annually, allowing deductions for expenses like mortgage interest, property taxes, and operating costs. If the ADU is used personally for more than 14 days or 10% of the total days rented, it is classified as personal use, limiting deductions.

This distinction also affects depreciation. For rental properties, homeowners can depreciate the ADU over 27.5 years, reducing taxable income. In contrast, depreciation is not available for ADUs primarily used for personal purposes. Mixed-use scenarios require proportional allocation of expenses. For example, if an ADU is rented for 100 days and used personally for 50 days, only two-thirds of the expenses can be deducted as rental expenses. Allocating shared costs like utilities or maintenance can be complex.

Mortgage Interest and Property Tax

Mortgage interest and property tax deductions for ADUs depend on their classification. For rental ADUs, deducting mortgage interest can significantly reduce tax liability. As of 2024, the IRS allows deductions on interest for up to $750,000 of mortgage debt for primary and secondary residences. For ADUs, the deductible portion corresponds to rental use.

Property tax deductions follow a similar approach. Homeowners can deduct property taxes on federal income tax returns, subject to the $10,000 cap on state and local tax (SALT) deductions. Only the portion attributable to rental use is deductible, requiring accurate allocation between personal and rental use.

Maintaining detailed records, including mortgage statements, property tax bills, and rental agreements, is essential to substantiate these deductions. Consulting a tax professional can ensure proper allocation and help maximize deductions.

Depreciation

Depreciation is a valuable tool for homeowners with ADUs classified as rental properties. It allows property owners to recover the cost of the ADU over its useful life, reducing taxable income. Under the Modified Accelerated Cost Recovery System (MACRS), residential rental properties, including ADUs, are depreciated over 27.5 years.

To calculate depreciation, the depreciable basis of the ADU must be determined, which is typically the purchase price plus improvements, minus land value. Improvements like energy-efficient upgrades can increase the depreciable basis and annual deduction. Recent tax reforms introduced bonus depreciation, permitting immediate expensing of qualifying property improvements. As of 2024, 80% bonus depreciation is available for eligible property, offering substantial initial deductions. Staying informed about legislative changes is important, as they can significantly influence tax planning.

Repairs and Maintenance

Repairs and maintenance for ADUs offer immediate tax advantages when properly classified. Routine repairs, such as fixing plumbing or replacing a broken window, are fully deductible in the year incurred. In contrast, capital improvements, like installing a new HVAC system, must be depreciated over time.

Homeowners should maintain detailed records of repair and maintenance expenses, including receipts and invoices, to substantiate deductions. Accurate documentation ensures compliance and helps claim all eligible deductions efficiently.

Separate Utilities and Insurance

Separating utilities and insurance for an ADU can simplify tax deductions. If the ADU has its own utility meters, the full cost of utilities can be deducted as rental expenses. For shared utilities, costs must be allocated based on usage, such as square footage.

Insurance costs also require attention. Homeowners should confirm whether their existing policy covers the ADU or if a separate landlord insurance policy is necessary. Landlord insurance, which covers rental-specific risks, is fully deductible. For mixed-use ADUs, insurance costs must be allocated accordingly. Consulting an insurance provider ensures proper coverage and cost optimization.

Recordkeeping for Tax Purposes

Effective recordkeeping is critical for ADU tax strategies. The IRS requires taxpayers to substantiate all deductions with proper documentation. This includes maintaining receipts, invoices, contracts, and bank statements related to ADU expenses. A well-organized system ensures compliance and helps maximize deductions.

Using dedicated financial accounts or accounting software like QuickBooks or Xero can streamline the process by categorizing expenses and storing digital copies of receipts. Keeping a detailed log of rental activity, including lease agreements and payments, is essential for accurately allocating expenses in mixed-use scenarios.

Comprehensive records are invaluable in the event of an IRS audit. The IRS can disallow deductions that lack adequate documentation, potentially leading to penalties or additional tax liabilities. Homeowners should retain records for at least three years after filing their tax return, or longer if claiming depreciation, as the IRS can audit depreciation schedules for as long as the property is in use. Periodic reviews with a tax professional can further ensure accuracy and compliance.